1

Answer all questions and label all graphs completely. Put in as much space as you need. To maximize
credit show all work. Submit the solutions in a Word file through.

Note: Complete all graphs electronically. If you need to draw a graph it is best to use PowerPoint and
then paste into Word. You may also use the drawing tools in Word directly. If you are not able to draw
the graphs correctly to include in your Word version, draw them by hand and scan them into a file to
submit with the test.

Chapter 1

Problem 1. You are the manager of a Fortune 500 hotel chain and must decide where to locate a new
hotel. Based on tax considerations, your accounting department suggests that Atlantic City is the best
choice, followed closely by Las Vegas. In particular, your current year tax savings from locating in
Atlantic City are $4 million, but they are only $3 million in Las Vegas. Your marketing department, on
the other hand, has provided you with sales estimates that suggest that the present value of the gross (of
taxes) operating profits from locating in Atlantic City are only $10 million, but they are $14 million for
Las Vegas. It will cost $14 million to build the hotel in either location. Ignoring all other considerations,
where should you build the hotel? What are your firm's economic profits if you locate the hotel in
Atlantic City?

Problem 2. Individuals who choose to attend school have made a decision to invest in human capital.
Use the terminology of net present value analysis to explain why you are attending school.

Chapter 2

Problem 3. Apples and oranges are substitutes. A freeze in Florida destroys most of the orange crop.
What would you expect to happen to the market for the following:

a. Oranges?
b. Apples?
c. Orange juice?


Problem 4. You are an economic advisor to the Treasurer of the United States. Congress is considering
increasing the sales tax on gasoline by $.03 per gallon. Last year motorists purchased 10 million gallons
of gas per month. The demand curve is such that every $.01 increase in price decreases sales by 100,000
gallons per month. You also know that for every $.01 increase in price, producers are willing to provide
50,000 more gallons of gasoline to the market. The legislature has stated that the $.03 tax will increase
government revenues by $300,000 per month and raise the price of gasoline by $.03 per gallon. Is this
correct?

Problem 5. Assume the current price of good X is too high (it is above the equilibrium price). In your
own words, describe the changes that would occur in a market as a result, i.e., explain how the market
would adjust to equilibrium.

Problem 6. The generalized demand and supply functions for good X are
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Qd = 60 2P + 0.01M + 7P
Y
Qs = 600

+ 20P

Where
Q
D
= quantity demanded of good X
P

= price of good X
M = consumer income
P
Y
= price of good Y


Q
S
= quantity supplied of good X
P

= price of good X

a. Are good X and good Y substitutes or complements? How do you know?

b. Is good X a normal good or an inferior good? How do you know?

c. What is the demand function when M = $40,000 and P
Y
= $20?

d. Find the inverse demand function.

e. Find the inverse supply function.

f. Solve for the equilibrium price (P
o
) and the equilibrium quantity (Q
o
).

g. Sketch the graph of this market.

Chapter 3

Problem 7. Your good friend owns a small town movie theatre. She currently charges $5 per ticket for
everyone who comes to the movies. Given the demand curves shown, answer the following questions:


Adult Demand
10 20 30 40 50 60 70 80 90 100
Quantity
1
2
3
4
5
6
7
8
9
10
Price
Child Demand
5 10 15 20 25 30 35 40 45 50 55 60 65 70
Quantity
1
2
3
4
5
6
7
8
9
10
Price
3

a. What is your current total revenue for both groups?

b. Just by looking at the graphs (no calculations) decide which market has more elastic demand
than the other. How can you tell?

c. What is the price elasticity of demand between the prices of $8 and $5 in the adult market? Is this
elastic or inelastic?

d. What is the price elasticity of demand between $5 and $2 in the childrens market? Is this
elastic or inelastic?

e. Given the graphs and what you know about economics, what do you recommend that your friend
charge for an adult ticket and for a child ticket? How much could your friend increase total
revenue if she takes your advice?

Problem 8. Briefly answer each of the questions below

a. If the price of ground beef falls from $7 to $4, and this leads to an increase in demand for beans
from 80 to 120 cans, what is the cross-price elasticity of beans and ground beef at a ground beef
price of $4?

b. A study sponsored by the American Medical Association suggests that the absolute value of the
own price elasticity for surgical procedures is smaller than that for the own price elasticity for
office visits. Explain why this would be expected.

c. The income elasticity of demand for your firm's product is estimated to be 0.75. A recent report
in The Wall Street Journal says that national income is expected to decline by 3 percent this year.
What do you expect to happen to your sales?

d. Your younger sister needs $500 to buy a new bike. She has opened a lemonade stand to make the
money she needs. She is currently charging $1.00 per cup, but wants to adjust her price to earn
the money faster. What is your advice to her? What assumption have you made about the price
elasticity of demand in this market?


Chapter 5

Problem 1. The total costs for Morris Industries are summarized in the following table. Based on this
information, fill in the missing entries in the table for fixed cost, variable cost, average fixed cost,
average variable cost, average total cost, and marginal cost.

(1) (2) (3) (4) (5) (6) (7) (8)
Q FC VC TC AFC AVC ATC MC
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0 1,000
10 2,000
20 2,500
30 4,000
40 6,000
50 10,000
60 15,000
Problem 2. Standard Enterprises produces an output that it sells in a highly competitive market at a price
of $100 per unit. Its inputs include two machines (which cost the firm $50 each) and workers, who can
be hired on an as-needed basis in a labor market at a cost of $2,800 per worker. Based on the following
production data, how many workers should the firm employ to maximize its profits?



Problem 3. You are the manager of a firm that sells output at a price of $40 per unit. You are interested
in hiring a new worker who will increase your firm's output by 2,000 units per year. Several other firms
also are interested in hiring this worker.
a. What is the highest annual salary you should be willing to pay this worker to come to your firm?
b. What will determine whether or not you actually have to offer this much to the worker to induce
her to join your firm?

Problem 4. The manager of a meat-packing plant can use either butchers (labor) or meat saws (capital)
to prepare packages of sirloin steak. Based on estimates provided by an efficiency expert, the firm's
production function for sirloin steak is given by Q = K + L
a. Graph the isoquant corresponding to 5 units of output.
b. What is the marginal product of capital and labor? Does the answer depend on how much labor
and capital are used?
c. If the price of labor is $2 per hour and the rental price of capital is $3 per hour, how much capital
and labor should be used to minimize the cost of producing 5 units of output?

Chapters 6 & 7
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Problem 5. Dallas-based Southwest Airlines recently announced a 10-year contract that gives pilots a
greater opportunity to share in the profits of the airline. According to the terms of the contract, the pilots
will receive options to buy 14 million shares of the firm's stock over the next 10 years. What impact do
you think this new contract will have on Southwest Airlines?

Problem 6. Firms like McDonald's and Wendy's sell hamburgers, salads, and other products that are
differentiated in nature. While numerous fast-food restaurants exist in most locations, the differentiated
nature of the firms' products permits them to charge prices that are in excess of marginal cost. Given
these observations, is the fast-food industry most likely a perfectly competitive industry, a monopoly,
monopolistically competitive, or an oligopoly? Please explain your reasoning

Problem 7. It is sometimes said that a manager of a monopoly can charge any price and customers will
still have to buy the product. Do you agree or disagree? Why?

Problem 8. Calculate each of the common economic industry measures below.
a. In Tuna, Texas, the retail gasoline market consists of six firms. Firm 1 has 35 percent of the
market, Firm 2 has 25 percent, and the remaining firms have 10 percent each. What is the four-
firm concentration ratio for this industry?
b. The widget industry is comprised of six firms of varying sizes. Firm 1 has 35 percent of the
market. Firm 2 has 25 percent, and the remaining firms have 10 percent each. What is the
Herfindahl-Hirschman index for the widget industry? Based on the U.S. Department of Justice
merger guidelines described in the text, do you think the Justice Department would be likely to
block a merger between firms 5 and 6?
c. Borris Industries operates in an industry that has a Rothschild index of 0.75. The firm gained
access to a government report that revealed the own-price elasticity of market demand within the
industry to be -3. Use this information to obtain an estimate of the own-price elasticity of
demand for the product produced by Borris Industries.
d. Zelda Manufacturing has a rather unique product that sells for $15 per unit, and the marginal cost
is $7.50. Determine the Lerner index for Zelda Manufacturing. Does this index indicate market
power?

Problem 9. Would integration between the following types of firms constitute a horizontal, a vertical, or
a conglomerate merger?
a. A food company and a drug company.
b. A milk producer and a cheese producer.
c. A computer chip manufacturer and a silicon producer.

Chapter 8

Problem 10. You are a manager in a perfectly competitive market. The price in your market is $35.
Your total cost curve is C(Q) = 10 + 2Q + .5Q
2
.
a. What level of output should you produce in the short run?
b. What price should you charge in the short run?
c. Will you make any profits in the short run?
d. What will happen in the long run?
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Problem 11. Why does the government grant patents to investors? Why does the government give
monopoly power to utility companies?

Problem 12. You are the manager of a firm that has an exclusive license to produce your product. The
inverse market demand curve is P = 900 - 1.5Q. Your cost function is C(Q) = 2Q + Q
2
. Determine the
output you should produce, the price you should charge, and your profits.

Problem 13. Suppose you are a monopolist operating two plants at different locations. Both plants
produce the same product; Q1 is the quantity produced at plant 1, and Q2 is the quantity produced at
plant 2. You face the following inverse demand function: P = 500 - 2Q, where Q = Q1 + Q2. The cost
functions for the two plants are



a. What are your marginal revenue and marginal cost functions?
b. To maximize profits, how much should you produce at plant 1? At plant 2?
c. What is the price that maximizes profits?
d. What are the maximum profits?

Problem 14. Would you expect an industry to be monopolistically competitive if consumers did not
value variety in the market? Explain.

Problem 15. What is the primary facet of monopolistic competition that does not allow for the
presence of long-run profits? If firms are making short-run profits in a monopolistically competitive
industry, what will eventually occur that will cause long-run economic profits to be zero?

Chapter 9

Problem 16. Explain where industry profits are maximized in the figure below:


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Problem 17. What real-world evidence would lead you to believe that firms were acting as Cournot
oligopolists? Stackelberg oligopolists? Bertrand oligopolists?

Problem 18. Zelda Industries is the only firm of its kind in the world. Due largely to historical
accident, it began producing streganomas in 1985 in a vacant warehouse. Virtually anyone with a
degree in college chemistry could easily replicate the firm's formula, which is not patent protected.
Nonetheless, since 1985 Zelda has averaged accounting profits of 6 percent on investment. This rate
is comparable to the average interest rate that large banks paid on deposits over the period. Do you
think Zelda is earning monopoly profits? Why?


Chapter 10

Problem 19. In a one-shot game, if you advertise and your rival advertises, you will each earn $5
million in profits. If neither of you advertises, your rival will make $4 million and you will make $2
million. If you advertise and your rival does not, you will make $10 million and your rival will make
$3 million. If your rival advertises and you do not, you will make $1 million and your rival will
make $3 million.
a. Write the above game in normal form.
b. Do you have a dominant strategy?
c. Does your rival have a dominant strategy?
d. What is the Nash equilibrium for the one-shot game?
e. How much would you be willing to bribe your rival not to advertise?

Problem 20. You operate in a duopoly in which you and a rival must simultaneously decide what
price to advertise in the weekly newspaper. If you each charge a low price, you each earn zero
profits. If you each charge a high price, you each earn profits of $3. If you charge different prices,
the one charging the higher price loses $5 and the one charging the lower price makes $5.
a. Find the Nash equilibrium for a one-shot version of this game.
b. Now suppose the game is infinitely repeated. If the interest rate is 10 percent, can you do
better than you could in a one-shot play of the game? Explain.
c. Explain how "history" affects the ability of firms in this game to achieve an outcome superior
to that of the one-shot version of the game.

Problem 21. Would collusion be more likely in the shoe industry or in the airline industry? Why?

Problem 22. Suppose Philips and Toshiba are the first companies to introduce digital versatile disk
(DVD) machines to the market. Studies by the firms suggest that consumers who purchase consumer
electronics are very brand-loyal. To capture future loyalties, each firm will attempt to maximize its
initial market share, for one time only, by setting prices. An economist has estimated the initial
market share of each firm under different pricing scenarios. Her results are captured in the following
payoff matrix:
8




a. Given this scenario, if you were in charge of pricing at Philips, what price would you
charge? Explain.
b. What market share would you anticipate as a result of your pricing strategy? Explain.





Problem 23. Refer to the normal-form game of price competition shown below.



Firm A must decide whether or not to introduce a new product. If firm A introduces a new product,
firm B must decide whether or not to clone the product. The payoff structure of the game is depicted
in the figure above. What is the subgame perfect Nash equilibrium?